What About the Risk Of a Bursting Asset Bubble?

The global economic policy world is in the midst of a debate over the risk of inflation, including the definition of the word "transitory." But what about the risk of the bursting of an asset bubble? What is surprising is the minimal amount of discussion about whether today's so-called "era of free money" has created dangerous asset bubbles. History shows that the bursting of asset bubbles can bring nasty macroeconomic consequences.

Note that in the United States alone, new corporate debt since the pandemic has skyrocketed. Mediocre companies have been able to buy back their stock. Wouldn't these firms be the first to collapse in a financial panic? Then again, does the fact that the Wall Street banks are so well capitalized minimize the negative effect to the broader U.S. economy from a panic-driven market correction? In such a correction, what would be the safe haven? U.S. Treasury bonds? Gold? Cryptocurrency? Commodities in general? If the latter, wouldn't there also be unpleasant macroeconomic consequences?

On a scale of one to ten, more than twenty noted observers rate the risks.

MOHAMED A. EL-ERIAN

President, Queens' College, Cambridge University; Chief Economic Adviser, Allianz; and author, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse (Random House, 2016)

Score: eight. Pockets of excessive and, in some cases, irresponsible risk-taking have been fueled by years of ample and predictable liquidity injections by the Federal Reserve and European Central Bank, the world's most systemically important central banks.

The context has been that of admirable dedication by central bankers to delivering their economic objectives, but one that has not been accompanied until recently by sufficient policy effectiveness on the part of other economic policymakers.

The Achilles heel has been the resulting and protracted over-reliance on the "financial asset channel" as the main transmission mechanism for macroeconomic policy to the real economy.

The unintended consequences and collateral damage have included a major disconnect between fundamentals and market valuations (Main Street versus Wall Street), deepening asset price distortions, over-borrowing, and widening resource misallocations.

This has all been turbocharged by behavioral factors including an overriding investor confidence in central banks always being the markets' best friend--or what's more commonly referred to as the "central bank put." This has encouraged too many investors to embrace the liquidity paradigm irrespective of the underlying fundamentals, and traders have piled on, surfing the enormous liquidity wave and over-extending the risk-taking both in scale and scope.

El-Erian, cont. The risk is not limited to the future credibility of central bank policies and the possibility of unsettling financial volatility. There is also the threat of widespread economic spillbacks and spillovers: to economic recoveries in the United States and Europe that need to be durable, strong, inclusive, and sustainable; and to developing countries whose financial resilience has been eroded and policy flexibility is more limited.

The solution lies in a timely rebalancing of the monetary/fiscal/structural policy mix, together with a major step up in macroprudential regulation, especially that pertaining to the non-bank financial sector.

THOMAS MAYER

Founding Director, Flossbach von Storch Research Institute, and former Chief Economist, Deutsche Bank Group

My answer to this question is: three. In his classic book on bubbles (Famous First Bubbles: The Fundamentals of Early Manias, MIT Press, 2000), Peter Garber wrote: "...'bubble' characterizations should be a last resort because they are non-explanations of events, merely a name that we attach to a financial phenomenon that we have not invested sufficiently in understanding."

So what is the phenomenon in financial markets that many call a "bubble" today? My understanding is that it is the result of a monetary policy, prevalent in almost all industrial countries, that has driven interest rates to historical lows, and in the course of the Covid-19 pandemic induced the creation of a monetary overhang of a size previously only seen in times of war. Low interest rates raise asset valuations while excess cash balances induce portfolio reallocations towards other financial and real assets.

This phenomenon will only disappear when central banks put their policy in reverse gear. But since they have become prisoners of fiscal policymakers and financial markets, I assign a relatively low probability to a meaningful tightening of monetary policy.

JEFFREY A. FRANKEL

Harpel Professor of Capital Formation and Growth, Harvard University's Kennedy School

My response: nine out of ten. Financial markets are indeed experiencing bubbles, spurred in part by easy money. Eventually the bubbles will end. A bursting could have severe adverse consequences for the real economy, as in 1929 or 2008; but that outcome is not guaranteed.

Asset prices are high by historical standards. For example, Shiller's ratio of U.S. stock prices to cyclically adjusted earnings is above 37 as of June 2021. It has been above 30 only twice before: 1929 and 2000.

A high price-to-earnings ratio need not imply that prices have overshot the present discounted value of future earnings, particularly during a time of innovation. But investors are innovating egregious bubble behavior.

Consider four recent examples:

* Cryptocurrencies. Bitcoin's price surged six-fold from October 2020 to April 2021.

* The GameStop bubble. The video-game retailer's stock price increased eighteen-fold in January 2021.

* The entire phenomenon of NFTs (non-fungible tokens).

* The boom in SPACs (special purpose acquisition companies). Their very definition calls to mind a notorious 1720 company prospectus in London's South Seas bubble: "an undertaking of great advantage; but nobody to know what it is."

ADAM S. POSEN

President, Peterson Institute for International Economics

Concern about a bubble should be driven by both how likely is a bubble underway, and how likely is it that a bubble in that particular asset class or sector will have destructive effects (through distortion or collapse). Scale of the overvaluation, of the sector or assets involved, or of average people's exposure can contribute to the impact of a bubble, but these are not sufficient statistics for predicting harm, and sometimes are quite misleading. Equity price bubbles, for example, rarely have persistent macroeconomic effects.

What matters most is the connectedness of the bubblelicious asset class and the leverage of the investors in it. As a result, the simple rule of thumb for when public policy should be concerned about a bubble is when it either involves residential real estate across a large part of the economy or the systemically important banking institutions. Large-scale housing price bubbles are almost sufficient to predict serious harms, as are over-leveraged banking systems. Absent either, it is rare that bubbles do much harm.

So, I currently am at a seven out of ten in concern on the lookout to raise my alarm because of recent developments in U.S. housing markets. At the start of 2020, prior to the pandemic, I would have given it a 4, since the bubbles at the time--and most of the ones since--have been in assets which don't matter. The resilience of the core U.S. banking system to the pandemic shock of spring 2020 and to the Archegos collapse this year vindicates the capital requirements and stress tests of today, and therefore reassures me. But widespread housing price bubbles do almost always mean trouble.

JOSEPH E. GAGNON

Senior Fellow, Peterson Institute for International Economics

My concern about asset bubbles is two on a scale from one to ten.

A bubble exists when the price of an asset greatly exceeds its fundamental value. That is not the case at present for any of the main asset classes: bonds, equity, and real estate. All of these assets are expensive by historical standards, as one would expect when interest rates are near zero. Future rents, profits, and coupon payments are discounted at a low rate. Nevertheless, asset prices remain volatile and difficult to...